Hope everyone is managing this current market volatility well.
With all the news, fake news and half-truths surrounding the Coronavirus, it is easy to be swept up in the confusion surrounding what is true and what is not. Just look at the extreme volatility in the markets.
Which is why now is more important than ever to practice independent thinking.
A case in point is when finance professor Jack Traynor placed a jar of jellybeans in front of his students in 1987.
He asked them to estimate how many beans were in the jar.
The students attempted to count the beans, or estimate the beans per volume, or other such things to get their best estimate.
Traynor found that the average of the guesses came very close to the actual number of beans.
But the average of the guesses beat all but one or two guesses.
In other words, only one or two students actually did better than the average of the whole group.
This effect is known as the “wisdom of crowds”.
A crowd of bean guessers can be highly intelligent as a whole so long as their guesses remain independent.
Now what if we replace these beans with the stock market?
As a collective, market guesses on asset prices come really close to the true value.
But it’s not perfectly accurate. Instead, the prices are close enough that little to no opportunity exists to earn a higher return (in most cases).
So, in most cases, buying the market will get you returns similar to the growth of the underlying businesses (over time) and nothing more.
This is why the market is hard to beat. And why the prevalence of indexing is so widespread.
But in times like today, inefficiencies exist that create opportunities.
Independent errors (the wrong guesses) happen in a large pool of bean guessers.
So long as the pool is diverse and the guesses independent, the randomness of it all averages out to a collectively great guess.
But shared errors turned the wisdom of crowds upside down.
Joel Greenblatt offered a simpler example of how shared error works by twice asking a class of ninth-graders how many jelly beans were in a jar.
The first time, he asked the students to write down their guess on an index card. Once everyone turned in their card, he asked them again but to give their answer out loud. Only this time, they could keep their first guess or change it.
The average of the first guess, written on the cards, was off by 5 jelly beans. But the average of the second guess, announced out loud, fell to roughly half the actual number of jelly beans.
The kids, upon hearing their class-mates guesses, collectively changed their answers for the worse.
This is how the stock market works, because everyone is reading the same newspapers, the same media articles and the same research reports.
The initial guess, when they were independent and counting the rows and trying to figure out what was actually going on, was the better guess.
It’s a simple example of how easily shared error — biases — can be injected into market prices.
Opportunities exist for this reason.
However, the difficulty is in recognizing the opportunities. Every ninth-grader who changed their answers for the worse thought it was for the better. Now how often do investors believe they made the wrong decision? And if decisions are easily swayed, it makes it hard to see real opportunities.
And it doesn’t take much to sway decisions. Something as simple as published stock prices are enough to influence an investor’s guess. This is why Buffett only looks at a stock’s price after he’s done a valuation.
So independent thinking is key.
A timely reminder during times like these.
Trade Safe!
Disclaimer: The information above is for educational purposes only and should not be treated as investment advice. The strategy presented would not be suitable for investors who are not familiar with exchange traded options. Any readers interested in this strategy should do their own research and seek advice from a licensed financial adviser.
